Insurance IFRS Seminar Hong Kong, August 3, 2015 Eric Lu Session 18 Discounting Insurance IFRS Seminar Hong Kong, August 3, 2015 Eric Lu Session 18

Assets valued at market value (assumed) Background Liability = Assets Assets valued at market value (assumed) Fixed Income Asset market value = discounted cash flow Thus Liability = discounted insurance cash flow

Question? What discount rate to use? Ideal Answer: Replicating portfolio Identical cash flows Identical characteristics (e.g. liquidity, risk, etc.) Doesn’t exist (except for GIC?)

2013 Exposure Draft ED Paragraphs 25 – 26 Application Guidance B69 – B75

Discounting Required 25 An entity shall determine the fulfilment cash flows by adjusting the estimates of future cash flows for the time value of money, using discount rates that reflect the characteristics of those cash flows.

Discount rates consistent with observable current market prices for instruments with cash flows whose characteristics are consistent with those of the insurance contract, in terms of, for example, timing, currency liquidity;

Discount Rates, Cont. exclude the effect of any factors that influence the observable market prices but that are not relevant to the cash flows of the insurance contract

Discount Rate Consistency 26 Estimates of discount rates shall be consistent with other estimates used to measure the insurance contract to avoid double counting or omissions, for example:

Consistency, Cont. (a) to the extent that the amount, timing or uncertainty of the cash flows that arise from an insurance contract depends wholly or partly on the returns on underlying items, the characteristics of the liability reflect that dependence. The discount rate used to measure those cash flows shall therefore reflect the extent of that dependence.

Asset Dependencies Non Participating Unit Linked Bond Yield 10% Tax @ 30% -3% 0% Default -2% Discount Rate 5% 8%

Consistency, Cont. (b) nominal cash flows (ie those that include the effect of inflation) shall be discounted at rates that include the effect of inflation. (c) real cash flows (ie those that exclude the effect of inflation) shall be discounted at rates that exclude the effect of inflation.

Discount Rates Characteristics Risk Asset Liability Currency Yes Contract Features Default No Expense Inflation Liquidity Sovereign Tax Timing Uncertainty

Liquidity examples European example Illiquidity Product 100% Immediate annuity in payment 75% Participating general account product General account product with guarantees less than 10 year rate 50% Protection (e.g. term life) products with annual premiums 0% Unit linked European example

Application Guidance B69 - No directly observable rates B70 - Include relevant factors B71 – Unavailable observable market B72 – Asset dependency B73 – No asset dependency B74 – No portfolio restrictions B75 – Dependency approaches

Not directly observable B69 Discount rates that reflect the characteristics of the cash flows of an insurance contract may not be directly observable in the market. Maximise the use of current observable market prices of instruments with similar cash flows, Adjust to reflect the differences between those cash flows and the cash flows of the insurance contract in terms of timing, currency and liquidity. Standard does not prescribe the method for making those adjustments.

Interest Rate Approaches Bottom Up Start with risk free rate Add liquidity premium, etc. Top Down Start with observed yields Remove default premium, etc.

Interest Rate Approaches Rate / Adjustment Top Down Bottom Up Bond Gross Yield 10% Tax @ 30% -3% Default -2% Discount Rate 5% Liquidity 2% Risk Free Rate 3%

Include Relevant Factors B70 In making the adjustments described in paragraph B69, an entity shall include in the discount rates for the insurance contract only those factors that are relevant for the insurance contract, as follows: .

“Top-down” Approach Determines yield curve for the insurance contract based on yield curve that reflects the current market rates of returns either for the actual portfolio of assets that the entity holds or for a reference portfolio of assets The rates of return for the portfolio include market risk premiums for credit risk and liquidity risk.

In a ‘top-down’ approach (i) exclude, from the observable rates of return that apply to a portfolio of assets, its estimates of the factors that are not relevant to the insurance contract. Such factors include market risk premiums for assets included in the portfolio that are being used as a starting point.

(iii) does not include the risk of the entity’s own non-performance “Top-down”, Cont. (ii) adjusts for timing differences between cash flows of the assets in the portfolio and the timing of the cash flows of the insurance contract. This ensures that the duration of the assets is matched to the duration of the liability. (iii) does not include the risk of the entity’s own non-performance

“Top-down”, Cont. While there may be remaining differences between the liquidity characteristics of the insurance contract and the liquidity characteristics of the assets in the portfolio, an entity applying the top-down approach need not make adjustments to eliminate those differences.

“Bottom-up” Approach (b) Entity adjusts risk-free yield curve to include its estimates of the factors that are relevant to the insurance contract (a ‘bottom-up’ approach).

“Bottoms-up” Liquidity Example Liquidity characteristics of the financial instruments underlying observed market rates different from insurance contract. Example: Government bonds traded in deep and liquid markets the holder can sell readily at any time without incurring significant transaction costs such as bid-ask spreads. In contrast, insurance contract liabilities cannot generally be traded, and may not cancel contract

Observable Market unavailable B71 When observable market variables are not available, or do not separately identify the relevant factors, use estimation techniques to determine the appropriate discount rate, taking into account other observable inputs when available.

Observable Market Unavailable Example 1, discount rates applied to cash flows beyond available observable market data extrapolate from current, observable market yield curve for shorter durations. Example 2, credit risk premium included in the spread of a debt instrument using a credit derivative as a reference point. Assess extent to which the market prices for credit derivatives includes factors not relevant to determining the credit risk component of the market rate of return so that the credit risk component of the overall asset spread can be determined.

Non Dependency on Assets B72 In principle, the discount rates that are not expected to vary with returns on underlying items will result in the same yield curve for all cash flows because the different liquidity characteristics of the contracts will be eliminated to result in an illiquid risk-free yield curve that eliminates all uncertainty about the amount and timing of cash flows. However, “top-down” approach may result in different yield curves in practice, even in the same currency.

Dependency B73 To the extent that the amount, timing or uncertainty of the cash flows that arise from an insurance contract depends on the returns on underlying items, liability characteristics required to reflect that dependence. The discount rates used to measure those cash flows reflect the extent of that dependence. Regardless of whether dependence arises from contractual terms or through the entity exercising discretion, and regardless of whether the entity holds the underlying items.

Portfolio Restrictions B74 The Standard does not specify restrictions on the portfolio of assets used to determine the discount rate “top-down”. Fewer adjustments would be required to eliminate irrelevant factors when reference asset portfolio has similar characteristics to insurance contract liabilities.

“Top-down” guidance (bond) for debt instruments, objective is to eliminate from total bond yield factors not relevant for insurance contract: expected credit losses, market risk premiums for credit and liquidity.

“Top-down” Guidance (equity) (b) for equity investments, more significant adjustments are required to eliminate factors not relevant to insurance contract. Greater differences between the cash flow characteristics of equity investments and insurance. Objective is to eliminate from the portfolio rate expected return for bearing investment risk. market risk and any other variability in amount/timing of asset cash flows.

Dependence Approaches B75 In some circumstances, the most appropriate way to reflect any dependence of the cash flows that arise from an insurance contract on specified assets might be to use a replicating portfolio technique.

Dependence, Cont. In other cases, an entity might use discount rates that are consistent with the measurement of those assets, and that have been adjusted for any asymmetry between the entity and the policyholders in the sharing of the risks arising from those assets.

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